What is Convertible Note?

“A convertible note, also known as a convertible promissory note or simply a “”convertible,”” is a type of financial instrument commonly used in startup financing and early-stage investments. It is essentially a form of debt that has the potential to convert into equity (ownership) in the company at a later date, typically when certain predefined conditions are met. Convertible notes are often used by startups to raise capital from angel investors, venture capitalists, or other early-stage investors.

Here are the key features of a convertible note:

1. Principal Amount: The investor lends money to the startup, and this amount is documented in the convertible note as the principal amount. This principal amount is typically repayable to the investor at a future date, usually when the note matures.

2. Interest Rate: Convertible notes may accrue interest over time, similar to traditional loans. However, the interest is usually lower than market rates and may be deferred, meaning it is not paid out regularly but added to the principal and potentially converted into equity later.

3. Conversion Trigger: The primary feature of a convertible note is its conversion into equity. This conversion typically occurs when certain triggering events happen, such as the company raising a subsequent round of financing (e.g., a Series A funding round) or reaching a specific valuation threshold. The conversion terms, including the conversion price, are outlined in the note.

4. Conversion Price: The conversion price determines how many shares of equity the investor receives for each dollar invested. This price is typically set at a discount to the valuation established in the subsequent financing round, which benefits early investors by giving them more shares for their investment.

5. Maturity Date: Convertible notes have a maturity date, which is the point at which the note becomes due for repayment. If the triggering events for conversion do not occur before this date, the startup is typically obligated to repay the principal and any accrued interest to the investor.

6. Conversion Cap: In some cases, convertible notes include a conversion cap, which places a limit on the valuation at which the note can convert. This cap protects the investor from excessive dilution if the startup achieves a very high valuation in a subsequent financing round.

Convertible notes are a popular financing tool in the early stages of a startup’s life because they provide a way to raise capital quickly without immediately determining the company’s valuation. This can be beneficial for both investors and founders, as it allows them to defer the equity valuation negotiation to a later date when there may be more information and a clearer understanding of the company’s value. However, the terms of convertible notes can be complex, so it’s essential for both parties to carefully consider and negotiate the terms to ensure a fair deal.”